Case of the Week
Exit Strategies for Real Estate Investors, Part 4
Case:Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. Karl's passion was real estate, and he was very successful in his investments.
Karl continued to buy and sell real estate at the age of 85. About three months ago, Karl discovered a great investment property. It was a "fixer-upper" commercial building in a great area. While other buildings nearby sold for over $2 million, the seller needed to sell quickly and was asking for just $1 million.
The condition of the building turned many buyers away. It was being sold "as-is," but Karl was not deterred. He could see great potential with the building and knew it would not take much to get it to market condition. Therefore, Karl swooped in, bought the building for $1 million and hired contractors to refurbish the place.
After three months of hard work refurbishing the building, the place looked like new! In the end, Karl invested $250,000 in the building, bringing his total investment in the property to $1.25 million. One month after the completion of the work, Karl was contacted informally by a company that expressed an interest in the building – a $2 million interest! This was no surprise to Karl. He knew the building was another great buy.
After Karl learned about the benefits of a FLIP CRUT, he eagerly wanted to move forward. (See Parts 1 and 2 for a full discussion of this decision.) It looked like the perfect solution.
Question:However, there was still one unresolved issue. There was a $100,000 debt on the property that Karl incurred at the time of purchase. Thus, he wanted to know what effect, if any, the $100,000 mortgage would have on the FLIP CRUT plan?
Solution:Karl's situation is not an uncommon situation. Indeed, the majority of real estate is encumbered by some amount of debt. Unfortunately, mortgaged real estate and charitable remainder trusts (CRTs) generally do not mix well. The transfer of debt-encumbered property into a CRT triggers two potential problems: 1) grantor trust status that results in disqualification of the trust, and 2) debt-financed income, which may require a 100% tax on unrelated taxable income.
If the debt obligation is solely against the property, the debt is termed "nonrecourse." If the obligation is against both the property and the owner personally, the debt is termed "recourse." The IRS states that the transfer of recourse debt into a CRT will reclassify the trust as a grantor trust. See PLR 9015049. Since a CRT cannot be a grantor trust, the trust will cease to qualify as a CRT.
If the debt is deemed nonrecourse, then there is no personal liability under Sec. 677 and, accordingly, no grantor trust status problem. Thus, in the event of nonrecourse debt, it may be permissible to transfer the real estate into the CRT without disqualifying the trust.
However, in most cases, real estate debt is recourse. Nevertheless, it is important to verify the nature of the debt. Therefore, after contacting his lender, Karl learns that he is personally liable for the debt (i.e., the debt is considered recourse debt). Therefore, he knows this poses a significant problem, since his FLIP CRUT cannot safely accept the gift of real estate now.
Even if the debt were nonrecourse, to avoid a debt-financed income problem to the CRT it is imperative that the mortgaged property pass the "5 and 5" rule. Simply put, the nonrecourse debt needs to be more than five years old and the property owned for more than five years. (For a review of the "5 and 5" rule, see GiftLaw Pro 2.1.2.) If the "5 and 5" rule is not met, then the CRT may have debt-financed income (i.e., UBI) upon sale of the property. If this occurs, then the CRT is fully taxable. Because UBI is subject to a 100% excise tax, this would largely deplete the trust. Accordingly, debt-financed income inside a CRT should be avoided at all costs.
In this instance, Karl also fails the "5 and 5" rule because the debt is not five years old. Thus, Karl is dealing with a second significant problem, since debt-financed income will subject the trust to huge taxation.
Karl now realizes that his $100,000 mortgage poses a double dip of disaster. Part 5 of this series will discuss Karl's options and what he will need to do in order to proceed with his FLIP CRUT plan.